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Learning Outcomes Chapter 11

Compute the component cost of capital for (a) debt, (b) preferred stock, (c) retained earnings, and (d) new common equity. Describe the weighted average cost of capital (WACC) and discuss the logic of using WACC to make informed financial decisions. Describe how the marginal cost of capital (MCC) is used to make capital budgeting decisions. Discuss the relationship between the firms weighted average cost of capital (WACC) and investors required rates of return.

Cost of Capital
Firms average cost of funds, which is the average return required by firms investors What must be paid to attract funds

Required Rate of Return (Opportunity Cost Rate)

The return that must be raised on invested funds to cover the cost of financing such investments

Basic Definitions
Capital Component

Types of capital used by firms to raise money

rd = before tax interest cost rdT = rd(1-T) = after tax cost of debt

rps = cost of preferred stock

rs re = cost of retained earnings = cost of external equity (new stock)

Basic Definitions
WACC Weighted Average Cost of Capital Capital Structure A combination of different types of capital(debt and equity) used by a firm

After-Tax Cost of Debt

The relevant cost of new debt

Taking into account the tax deductibility of interest

Used to calculate the WACC

Cost of Preferred Stock

Rate of return investors require on the firms preferred stock

The preferred dividend divided by the net issuing price

F = percentage flotation costs as a decimal NP0 = per share net proceeds firm receives from the issue
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Cost of Retained Earnings

Rate of return investors require on the firms common stock

rs = required rate of return RPs = risk premium for Stock S s = expected rate of return r g = constant growth rate rRF = risk-free rate of return P0 = current stock price = next periods expected dividend D 1
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The CAPM Approach

rs rRF rM RPs s

= cost of retained earnings = risk-free rate of return = risk-free rate of return = risk premium for Stock S = beta coefficient for Stock S

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The Discounted Cash Flow Approach (Expected Rate of Return)

Price and expected rate of return on a share of common stock depends on the dividends expected on the stock.

rs = cost of retained earnings P0 = current stock price s = expected rate of return r g = constant growth rate = next periods expected dividend D 1
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The Bond-Yield-Plus-Premium Approach

Estimating a risk premium above the bond interest rate Judgmental estimate for premium Ballpark figure only

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Cost of Newly Issued Common Stock

External equity, re
Based on the cost of retained earnings Adjusted for flotation costs (the expenses of selling new issues)

re = cost of new equity g = constant growth rate = next periods expected dividend D 1 F = percentage flotation cost stated as a decimal P0 = current stock price
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Target Capital Structure

Optimal Capital Structure
Percentage of debt, preferred stock, and common equity in the capital structure that will maximize the price of the firms stock

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Weighted Average Cost of Capital, WACC

A weighted average of the component costs of debt, preferred stock, and common equity

wd = proportion of debt in firms capital structure wps = proportion of preferred stock in firms capital structure ws = proportion of common stock in firms capital structure

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The Logic of the Weighted Average Cost of Capital

The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project.

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Marginal Cost of Capital

Marginal Cost of Capital Schedule
A graph that relates the firms weighted average of each dollar of capital to the total amount of new capital raised Reflects changing costs, depending on amounts of capital raised

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MCC Schedule for Unilate Textiles

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Break Point (BP)

The dollar value of new capital that can be raised before an increase in the firms weighted average cost of capital occurs

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MCC Schedule Using Retained Earnings, New Common Stock and Higher-Cost Debt

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Combining the MCC and Investment Opportunity Schedules

Use the MCC schedule to find the cost of capital for determining projects net present values. Investment Opportunity Schedule (IOS)
Graph of the firms investment opportunities ranked in order of the projects internal rate of return

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Combining the MCC and Investment Opportunity Schedules

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